Full Disclosure Finance

By Justin

You may have heard about the good news handed down in the recent federal budget by Finance Minister Jim Flaherty regarding a tax-free savings account.

This is good news by the way! Big business was looking for more, but a tax free savings account was long overdue considering the US has had the Roth IRA since 1998. Many other good ideas have been published in recent editorials, but most of these debate the merits of this program relative to other options. This minimizes the importance of putting something in place to shelter gains for the average Canadian and generate more action from the retail investor.

The new Tax Free Savings Account (TFSA) differs from a Roth IRA in the following ways:

1) Roth IRA withdrawals are tax free once you turn 59.5 years old and you have had the account open for 5 years. The TFSA provides full flexibility to withdraw and contribute, at any age, in any amount.
2) Annual contribution limits for the TFSA do not depend on age, whereas the Roth has higher limits for those 50 and over.

Here are more details on the TFSA as they apply to Canadian citizens:

• Canadians 18 and older can contribute a maximum of $5000 per year.
• Contributions are not deductible for income tax purposes, however, all capital gains and investment income earned in the TFSA are NOT TAXED.
• Unused room can be used in the future. For example, if you contribute $2000 in one year, you then have $3000 of room that can be used in any future year. The next year you could put in $8000 if you wanted.
• Funds can be withdrawn and put back in at any time without affecting your contribution limit.
• You are allowed to contribute to a spousal TFSA.

Okay, the verbiage is officially over. What does all of this mean? Who does this account favour?

This means we now have polar opposite investment vehicles, as seen in the diagram below:

In terms of who will get the maximum absolute benefit, it will be those in the highest tax bracket. This is because their personal tax rates are highest (as high as 46.1%), so they would be saving the most with a tax free account.• Investments with interest income are taxed at the maximum rate (your personal income tax rate). Interest income can come from GIC’s, bonds, high interest savings accounts, and private loans. Some income trusts classify part of their distribution as interest income and part as a dividend.

• Dividends received from foreign companies are taxed at 100% of their value rather than being grossed up by 45% and then subtracting a federal and provincial dividend tax credit. Therefore, foreign dividends are also some of the highest taxed investment products.

A TFSA offers greater savings for these investments because you pay a higher tax rate and would therefore have greater savings.

In terms of relative tax savings, it would be useful for everyone to put their investments that incur the highest level of tax in their TFSA. However, the analysis is complicated by the fact that one would contribute to both the TFSA and RRSP.

Anything you put into your RRSP will be taxed at your personal rate when you withdraw. This means capital gains, dividends, and interest income will all be treated the same upon withdrawal. Therefore, if you are choosing between putting something into your RRSP and your TFSA, it doesn’t make much difference what the taxation rates are on the investment types. It then becomes a decision of whether you want the tax savings now or later and if you have enough to maximize both accounts.

Small Business Owners: Here’s a little tidbit to leave you with. If you’re the owner of a small business and you’re paying yourself a dividend, not a salary, to keep your tax payments down, you won’t build up RRSP contribution room (because it is based on earned income). This means your RRSP contribution room will be small or non-existent and the TFSA could then be your only option.

I’m still learning more about the best strategy for the TFSA versus RRSP if you plan to contribute to both. Look for more on this topic from the major Canadian business magazines and us at FDF.